Last week, GOP leadership revealed its long-awaited plan to repeal and replace Obamacare by publishing the American Health Care Act. Rather than representing a unifying piece of legislation for the Republican party, however, the proposed legislation created an immediate division within the GOP, with many leading Republicans derisively calling the plan “Obamacare Lite” and others questioning the impact it would have on the number of insured individuals, or stated more appropriately, the number of insured voters in advance of the 2018 mid-term elections.

Despite the lukewarm reception with which it was met, the American Health Care Act moved through the House Ways and Means Committee along party lines; though it did require 18 hours of debate, with Democratic committee members decrying the Committee’s willingness to move the bill forward without a complete measure of its cost or the lost insured.

Yesterday, the Congressional Budget Office answered those questions, releasing its official scoring of the American Health Care Act, and the results are not pretty. An $883 billion tax cut, $274 billion of it going to the richest 2%. $880 billion stripped from Medicare. And 24 million fewer insured individuals over the next ten years.

Let’s take a look at how the CBO came up with the numbers it did. But first, we need to understand a bit about how Obamacare works.

That’s right: the circle of life is complete with regard to the penalties imposed on small employers who reimburse employees for premiums paid for health insurance purchased on the individual market. Let’s get caught up.

Sounds strange, but it’s true. After poring over Chief Justice Roberts’ opinion, the primary reason nearly every American will be required to own health insurance starting in 2014 or else be required to pay a penalty…err….tax to the IRS is because the required payment to the IRS under I.R.C. § 5000A is BOTH a penalty and a tax.

Allow me to explain.

Before the Supreme Court could determine whether the individual insurance mandate is constitutional, the justice’s first had to wrestle with the “Anti-Injunction Act.” The Anti-Injunction Act essentially provides that no suit may be brought against the government for imposing a tax until after the tax has been paid, at which point the payor could sue for refund. The purpose of this rule is obvious: to allow the government to impose revenue raising taxes and not have to fight through an endless string of lawsuits before they may begin to collect their revenue.

As a result, if the penalty imposed under I.R.C. § 5000A for failure to own health insurance were deemed to be a “tax” for purposes of the Anti-Injunction Act, the Supreme Court would be effectively barred from ruling on the constitutionality of the Patient Protection Act until 2015: the year taxpayers would have begun making payments on their tax return and could thus sue for refund. The Supreme Court, however, found that for these purposes — and as we’ll discuss later, only for these purposes — the amounts paid under I.R.C. § 5000A are a “penalty,” rather than a tax.

The Anti-Injunction Act applies to suits “for the purpose of restraining the assessment or collection of any tax.” §7421(a) (emphasis added). Congress, however, chose to describe the “[s]hared responsibility payment” imposed on those who forgo health insurance not as a “tax,” but as a “penalty.” §§5000A(b), (g)(2). Congress’s decision to label this exaction a “penalty” rather than a “tax” is significant because the Affordable Care Act describes many other exactions it creates as “taxes.”

Moving on to the highly-anticipated part of the decision, the Supreme Court was left to determine if requiring taxpayers to obtain health insurance was constitutional under two alternative arguments:

1. Did Congress have the power to enact the mandate under the Commerce Clause?

2. In the alternative, can the mandate be viewed not as an order to acquire insurance, but rather a tax to be borne by those who forego insurance? And if so, is such a tax within the powers of Congress?

Commerce Clause Argument:

The Supreme Court determined — by a 5-4 vote — that the individual insurance mandate was not constitutional under the Commerce Clause. The primary factor in the determination was that the Commerce Clause allows Congress to regulate commerce, not to compel Americans to enter into commerce they might otherwise refrain from:

The individual mandate, however, does not regulate existing commercial activity. It instead compels individ­uals to become active in commerce by purchasing a product, on the ground that their failure to do so affects interstate commerce. Construing the Commerce Clause to permit Con­gress to regulate individuals precisely because they are doing nothing would open a new and potentially vast do­main to congressional authority. Every day individuals do not do an infinite number of things. In some cases they decide not to do something; in others they simply fail to do it. Allowing Congress to justify federal regulation by pointing to the effect of inaction on commerce would bring countless decisions an individual could potentially make within the scope of federal regulation, and—under the Government’s theory—empower Congress to make those decisions for him.

To illustrate the Pandora’s box that could be opened by allowing Congress to initiate commerce, Justice Roberts used the following example:

Indeed, the Government’s logic would justify a manda­tory purchase to solve almost any problem. To consider a different example in the health care market, many Americans do not eat a balanced diet. That group makes up a larger percentage of the total population than those without health insurance. The failure of that group to have a healthy diet increases health care costs, to a greater extent than the failure of the uninsured to pur­chase insurance. Those in­creased costs are borne in part by other Americans who must pay more, just as the uninsured shift costs to the insured. Under the Gov­ernment’s theory, Congress could address the diet problem by ordering everyone to buy vegetables. That is not the country the Framers of our Constitution envisioned.

While the government posed the argument that all Americans — whether young, old, healthy, sick, insured or uninsured — will at some point need health insurance, and thus are all “active” in the health insurance marketplace, the Supreme Court was not convinced:

The Government repeats the phrase “active in the mar­ket for health care” throughout its brief, but that concept has no constitutional significance. An individual who bought a car two years ago and may buy another in the future is not “active in the car market” in any pertinent sense. The phrase “active in the market” cannot obscure the fact that most of those regulated by the individual mandate are not currently engaged in any commercial activity involving health care, and that fact is fatal to the Government’s effort to “regulate the uninsured as a class.” Everyone will likely participate in the markets for food, clothing, transportation, shelter, or energy; that does not authorize Congress to direct them to purchase particular products in those or other markets today. The Commerce Clause is not a general license to regulate an individual from cradle to grave, simply because he will predictably engage in particular transactions.

Taxing Powers Argument

Having held that the individual insurance requirement was unconstitutional under the Commerce Clause, the fate of Obamacare rested on whether the mandate could be imposed as part of Congress’ taxing powers.

Before it could address this argument, however, the justice’s had to be willing to look at the mandate another way. Rather than reading the requirement to obtain heath insurance or pay a tax as an “order,” it should be viewed as simply imposing a tax on those who do not buy the product. The court was willing to do so:

Under the mandate, if an individual does not maintain health insurance, the only consequence is that he must make an additional payment to the IRS when he pays his taxes. See §5000A(b). That, according to the Government, means the mandate can be regarded as establishing a condition—not owning health insurance—that triggers a tax—the required payment to the IRS. Under that theory, the mandate is not a legal command to buy insurance. Rather, it makes going without insurance just another thing the Government taxes, like buying gasoline or earn­ing income. And if the mandate is in effect just a tax hike on certain taxpayers who do not have health insurance, it may be within Congress’s constitutional power to tax.

Next, in order to determine whether the mandate was within the taxing powers of Congress, the Supreme Court — just pages after holding the mandate to be a “penalty” for purposes of the Anti-Injunction Act — would have to be convinced that the payment made to the IRS under I.R.C. § 5000A was actually a “tax” for constitutional purposes. Surprising many, the court made just that leap:

The exaction the Affordable Care Act imposes on those without health insurance looks like a tax in many re­spects. The “[s]hared responsibility payment,” as the statute entitles it, is paid into the Treasury by “tax­payer[s]” when they file their tax returns. 26 U. S. C. §5000A(b). It does not apply to individuals who do not pay federal income taxes because their household income is less than the filing threshold in the Internal Revenue Code. §5000A(e)(2). For taxpayers who do owe the pay­ment, its amount is determined by such familiar factors as taxable income, number of dependents, and joint filing status. §§5000A(b)(3), (c)(2), (c)(4). The requirement to pay is found in the Internal Revenue Code and enforced by the IRS, which—as we previously explained—must assess and collect it “in the same manner as taxes.” This process yields the essential feature of any tax: it produces at least some revenue for the Government. Indeed, the payment is expected to raise about $4 billion per year by 2017.

Thus, the Supreme Court was able to reconcile calling the mandate a “penalty” for purposes of the Anti-Injunction Act, but a “tax” for purposes of its constitutionality:

It is of course true that the Act describes the payment as a “penalty,” not a “tax.” But while that label is fatal to the application of the Anti-Injunction Act, supra, at 12–13, it does not determine whether the payment may be viewed as an exercise of Congress’s taxing power. It is up to Con­gress whether to apply the Anti-Injunction Act to any particular statute, so it makes sense to be guided by Con­gress’s choice of label on that question. That choice does not, however, control whether an exaction is within Con­gress’s constitutional power to tax.

In addition, because Congress left it up to us, the taxpayers, to decide whether to obtain insurance or pay the tax, with no potential for punitive sanctions or criminal prosecution, it carried the hallmarks of a constitutional tax.

And that’s how we got to where we are today: with an elated President Obama, a despondent Rush Limbaugh, and much of America shaking their heads and trying to make sense of how the same payment can be both a “penalty” and a “tax.”

Click for a PDF of the entire opinion — Supreme Court opinion — including the dissenting opinion of the four liberal justices who believed the mandate was within the powers of the Commerce Clause, as well as the dissenting opinion of the four conservative justices who found the mandate unconstitutional under both arguments.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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